Bitcoin and nearly all other cryptocurrencies are infamously volatile, capable of experiencing double-digit price swings in less than 24 hours. While this is an attractive feature for speculators looking to profit from price movements, it also remains one of the biggest barriers to the widespread adoption and legitimacy of cryptocurrency.
Enter stablecoins. These fixed-price digital currencies provide stability and a much wider range of everyday use cases than cryptocurrencies currently enjoy, and there are now more than 50 stablecoin projects being developed around the world.
Keep reading to find out how stablecoins work, the benefits they offer and why they’re important.
Disclaimer: This page is not financial advice or an endorsement of digital assets, providers or services. Digital assets are volatile and risky, and past performance is no guarantee of future results. Potential regulations or policies can affect their availability and services provided. Talk with a financial professional before making a decision. Finder or the author may own cryptocurrency discussed on this page.
What are stablecoins?
A stablecoin is a cryptocurrency with a fixed price. While the price of most cryptocurrencies is determined by supply and demand, stablecoins are designed to achieve a constant, stable price.
The most common method stablecoins use to achieve price stability is to peg the value of their coin to a real-world asset, for example gold or the US dollar. However, there are also a couple of other approaches for designing stablecoins, and we’ll explore all the options in detail a little further down the page.
Compare stablecoins side-by-side
Coin name
Issued by
Launched
Type of stablecoin
Features
AAA Reserve
Arc Fiduciary Ltd
2017
Fiat backed
Backed by cash, gilts and AAA-rated credit investments
AUDRamp (AUDR)
OnRamp Technologies
2018
Fiat backed
Backed by and pegged to AUD
A-Euro
Augmint
Not yet launched
Crypto backed
Pegged to EUR and backed by ETH
Bridgecoin (BRC)
Sweetbridge
Not yet launched
Fiat backed
To be backed by fiat, crypto, IPs, physical assets and more
Basis
Basis
Not yet launched
Seigniorage shares
Prices kept stable by algorithmically adjusting supply
BitUSD (BITUSD)
BitShares
2014
Crypto backed
Backed by BTS and pegged to USD
Boreal
Aurora
Not yet launched
Crypto backed
Backed by ETH and various cryptocurrencies
CarbonUSD
Carbon
Not yet launched
Seigniorage shares
Coin supply algorithmically adjusted based on demand. Pegged to USD
How do stablecoin creators achieve the price stability they desire? There are three different types of stablecoins, each with its own approach for ensuring minimal price fluctuations.
This is the simplest method of creating a stablecoin and is used by Tether (USDT), one of the best-known stablecoins in existence today. Fiat-collateralized stablecoins are backed by a real-world asset, most commonly the US dollar or some other fiat currency but also a traditional asset such as gold. That asset is owned and held by a central entity, with each unit of the stablecoin backed by a corresponding unit of the fiat currency.
For example, a stablecoin issuer accepts deposits in USD and issues one unit of stablecoin for every dollar it receives — the digital currency is effectively an IOU issued on that asset. If you decide you want to cash out 1,000 units of stablecoin, the coin issuer transfers you US$1,000 and “burns” 1,000 stablecoins.
While this method is reasonably easy to understand and implement, its main downside is that it requires a high level of trust in the central entity that controls USD deposits and issues the stablecoin.
And trust can be hard to come by in the crypto world. For example, Tether has long been the subject of accusations that not only is it used to prop up the price of bitcoin, but also that the company behind the currency (Tether Limited) doesn’t have sufficient USD reserves to back up the supply of Tether. At time of writing (October 2018), rumors of Tether’s insolvency continue to circulate online.
As an example of how a fiat-backed stablecoin works, check out the Tether price graph relative to the value of the USD below.
USDT’s price relative to the value of the US dollar Coincodex
Pros and cons of fiat-collateralized stablecoins
Pros
Easy to understand
Stablecoin’s value should match the value of a real-world asset
Cons
Required trust in third party to hold sufficient fiat collateral
Auditing required to make sure appropriate amount of collateral is being held — this can be slow and expensive
Uses a centralized structure that somewhat negates one of the key principles of cryptocurrency — decentralization
Relies on traditional fiat currency payment systems, which are slower and more expensive than cryptocurrency
The concept of crypto-collateralized stablecoins is fairly similar to that of fiat-collateralized stablecoins, but with the obvious difference that they’re backed by digital currency (or a basket of digital currencies).
They also need to account for the volatility of the cryptocurrency being offered as collateral. So while fiat-collateralized coins are backed on a 1:1 ratio by fiat deposits, crypto-backed stablecoin issuers hold crypto deposits of a ratio higher than 1:1. For example, you may need to deposit $500 worth of Ether (ETH) to access $250 worth of a stablecoin.
Because crypto-backed coins can be managed on-chain, there’s no need to worry about entrusting your deposit to a third party. However, the biggest concern is the volatility of the underlying collateral, so the coin issuer must hold a substantial amount of collateral to protect against significant price drops.
Pros and cons of crypto-collateralized stablecoins
Pros
You don’t have to entrust custody of your collateral to a third party — instead, collateral is locked up in a smart contract on the blockchain
Conducted on-chain, which ensures transparency and removes the need for third-party auditing that fiat-backed coins have
Cons
Requires extra collateral to be secure against cryptocurrency volatility
Risk of the asset collateralizing the stablecoin experiencing a significant decline in value
If backed by a basket of cryptocurrencies, selecting the right currencies to ensure price stability can be difficult
These stablecoins are controlled by an algorithm designed to match supply with demand in order to achieve price stability. Using smart contracts, supply is increased when the coin’s price goes up and decreased when it goes down, thereby maintaining the price at a steady level.
For example, if the price of the stablecoin is trading at above $1 per unit, the algorithm issues additional units to increase overall supply until the price returns to $1. The profits collected in this process are known as seigniorage.
If the price falls below the $1 mark, the algorithm is designed to use seigniorage to buy up some of the coins, thereby decreasing supply and pushing the price back up to $1. If the price is still below $1 and there are no more profits left to buy more of the coin’s supply, seigniorage shares are issued. These are basically bonds that raise funds for the coin issuer and promise future seigniorage profits to buyers.
Pros and cons of seigniorage shares
Pros
No collateral required
Theoretically protected against the volatility of other cryptocurrencies (however, a wider market downturn could lead to decreased demand for seigniorage shares)
Cons
More complicated than other structures
Relies on future growth in demand for the stablecoin in order to be successful — if there is no seigniorage left and seigniorage shares can’t be sold to raise funds, the price of the stablecoin could plummet
Largely unproven
A taxonomy of the main stablecoin types The State of Stablecoins, Blockchain.com
Why are stablecoins important?
While Satoshi Nakamoto’s vision for bitcoin was as a form of electronic cash, the world’s biggest cryptocurrency is rarely used as a medium of exchange on a day-to-day basis. Rather, its volatility and high fees mean that bitcoin is impractical for everyday transactions, and is instead used more as a store of value.
The same can be said for most other digital currencies. Because prices fluctuate significantly from one day to the next, holding and using crypto in the same way you do US dollars (getting paid a salary, paying for groceries, buying a coffee etc.) simply isn’t viable. Think about it — why would a business accept bitcoin as payment when 1 BTC might be worth $10,000 today, but tomorrow its value could have dropped to $9,000?
And this is, in theory at least, where stablecoins offer a key advantage. Not only do they offer all the benefits of cryptocurrency, including cryptographic security and the ability to transfer value digitally, but they’re designed to have the low volatility for which fiat currency is famous. The end result is a digital currency that can theoretically be used as a daily medium of exchange in the real world.
Stablecoin uses
What can stablecoins be used for? A price-stable cryptocurrency could potentially have a wide range of purposes, including:
Medium of exchange. A successful stablecoin could be used as a medium of exchange for everyday spending in the same way we currently use US dollars.
Protection against market volatility. When the crypto market is experiencing a downturn, shifting your money out of traditional digital currencies and into a stablecoin can help hedge against market volatility. This can be particularly useful if you use a crypto exchange that doesn’t support fiat currency.
Financial products. Stablecoins could potentially form the basis for a new financial ecosystem, including everything from crypto-backed loans and global remittances to insurance, as they provide the long-term stability required for many financial functions.
Prediction markets. If you place a bet on the outcome of an event with a long time frame, using a stablecoin allows you to minimize the impact of market volatility.
Global access to a stable currency. In countries where the local currency is plagued by hyperinflation, holding a decentralized stablecoin could allow people to protect their wealth.
Bottom line
There’s little doubt that a working, trusted stablecoin is a key stepping stone on cryptocurrency’s path to mainstream acceptance. However, this goal is still some way off.
There have been numerous examples in recent years of stablecoin projects that have simply failed to stand the test of time. Even Tether, the world’s largest (in terms of market cap) stablecoin and one that’s been around since 2015, has been plagued by accusations that it doesn’t have sufficient US dollar reserves to back up the amount of USDT in circulation.
In The State of Stablecoins, a report from wallet provider Blockchain released in September 2018, the authors summed up the current situation in the stablecoin market by saying:
“While there is a great deal of excitement surrounding stablecoins, the technology is still nascent and it is highly unlikely that the perfect stablecoin design exists at present; further experimentation (and innovation) is expected.”
While some stablecoins have been able to demonstrate short-term stability, only time will tell whether they’ve got the goods to provide long-term reliability. Until that happens, don’t assume that any cryptocurrency will be able to provide the same stability as good old-fashioned fiat currency. And if you’re thinking of putting any of your hard-earned cash into a stablecoin project, make sure you thoroughly research it first.
FAQs
Where can I buy stablecoins?
This depends on the coin you want to buy. While well-known stablecoins like Tether and Dai are listed on a wide range of cryptocurrency exchanges, many other coins are less widely available. Do your research to find out where you can buy your chosen currency.
How and where can I buy Tether?
You can find step-by-step instructions on this in our guide to how to buy USDT.
Disclaimer: Cryptocurrencies are speculative, complex and involve significant risks – they are highly
volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of
future performance. Consider your own circumstances, and obtain your own advice, before relying on this information.
You should also verify the nature of any product or service (including its legal status and relevant regulatory
requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may
have holdings in the cryptocurrencies discussed.
Picture: Shutterstock
Disclosure: At the time of writing the author holds ADA, ICX, IOTA, POWR and XLM.
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Werner Vermaak is a technical writer and blockchain consultant with an extensive 20-year marketing resume across Taiwan, the UK and South Africa. He came across Bitcoin and cryptocurrency in Taiwan during mid-2017 and has worked with several companies and projects in the areas of crypto security, regulations, custody and new fields such as DeFi, NFTs and Web 3.0 since. Werner has a business degree from Stellenbosch University and postgraduate qualifications in strategic marketing from the AAA School of Advertising. Werner enjoys geeking out on new technology and pondering the mass adoption of digital assets.
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